Classic Pen had been the low-cost producer of traditional blue and black pens, profit margins were over 20% of sales. 5 years ago, red pens were introduced with a 3% premium. Last year, purple pens were introduced. They have a 10% premium on the selling price.

Red and purple are more profitable than blue and black. However, profitability is down and even the new products are not earning the margins that were seen when it was just black and blue pens. Purple pens have a much higher margin though.

5 years ago, when just black and blue were produced the changeover ran smoother due to the length of production runs and there wasnt much changeover. When introducing red we now have to stop production. Empty the vats, clean out the previous color, and start red production. With black and blue we only had to do this with blue. With red pens, any trace amount of another color and the quality is ruined whereas with other colors it's easier. Even new purple, while demanding specifications does not have as many as red.

We seem to be spending a lot more time on purchasing and scheduling activities and just keeping track of where we stand on existing, backlogged, and future orders. The new computer system helped. However, there are rumors of adding more colors. The CEO doesnt know if they are able to handle additional confusion and complexity in the system.

Each product had a bill of materials that identified the quantity and cost of direct materials required for the product. A routing sheet identified the sequence of operations required for each operating step. This information was used to calculate the labor expenses for each of the four products. All of the plant's indirect expenses were aggregated at the plant level and allocated to products based on their direct labor content. Currently, this overhead burden rate is 300% of direct labor costs. Most people in the plant recalled that not too many years ago the overhead rate was only 200%.

The CEO went to a seminar and they talked about a new concept called activity-based costing (ABC). THis concept seemed to address so many problems. The CEO should have argued that overhead should not be viewed as a cost or a burden to be allocated on top of direct labor. Rather the organization should focus on activities performed by the indirect and support resources of the organization and try to link the cost of performing these activities directly to the products for which they were performed.

The CEO first identified six categories of support expenses that were currently being allocated to pen production:

expense category	Expense
indirect labor	$20,000
fridge benefits	$16,000
computer systems	$10,000
machinery	$8,000
maintenance	$4,000
energy	$2,000
total	$60,000

It was determined that the fringe benefits were 40% of labor expenses (both indirect and direct) and would represent just a percentage markup to be applied on top of direct and indirect labor charges.

When talking to the department heads there were three main activities accounting for their work. Half of the indirect labor was involved in schedules or handling production runs. This includes scheduling production orders, purchasing, etc. Another 40% of indirect labor was requested just for the physical changeover from one color to another. In order to change to Black only takes an hour. Other colors required longer changeover times. The remaining 10% of the time was spent maintaining records.

Next, the CEO focused on the $10,000 in expenses to operate the companys computer system. Since each production run was made for a particular customer, the computer time required to prepare shipping documents and invoicing from a customer was also included in this activity. In total, about 80% of the computer resource was involved in the production run activity. Almost all of the remaining computer expenses (20%) were used to keep a record of the four products, including the production process and associated engineering change notice information.

The remaining three categories of overhead (machine depreciation, machine maintenance, and the energy to operate) were incurred to supply the machine's capability to produce the pens. The machines had a practical capability of 10,000 hours of productive time that could be supplied to pen production.

Traditional income statement
	Blue	Black	Red	Purple	Total
Sales	75000	60000	13950	1650	150600
material cost	25000	20000	4680	550	50230
direct labor	10000	8000	1800	200	20000
overhead @ 300%	30000	24000	5400	600	60000
total operating income	10000	8000	2070	300	20370
return on sales	13.60%	13.30%	14.80%	18.20%	13.50%
Direct Costs and activity cost drivers
	Blue	Black	Red	Purple	Total
Production Sales Volume	50000	40000	9000	1000	100000
Unit Selling Price	15	1.5	1.55	1.65
Materials unit costs	0.5	0.5	0.52	0.55
direct labor hr/unit	0.02	0.02	0.02	0.02	2000
machine hours/unit	0.1	0.1	0.1	0.1	10000
production runs	50	50	38	12	150
setup time/run	4	1	6	4
total setup time	200	50	228	48	526
parts admin	1	1	1	1	4